AP Macro
Economics
Review
Peggy Pride, Presenter
Production Possibility Curve
B2
Capital
goods
Capital
goods
B
D2
D
A
B
C
F
W
Consumer goods
D
E
Consumer goods
Market
Equilibrium
P
r
i
c
e
Supply
Pe
Demand
Qe
Quantity
A change in Demand versus a change in
the Quantity Demanded
Change in Demand
Change in Quantity
Demanded
√ Moves the curve
•Income
•Future Expectations
•# of Buyers
√ Moves Along the SAME
curve
• Caused only by Price
change.
•Consumer Information
•Taste and Preference
•Substitues and Complements
Price Change
Price of Corn
P
CORN
P
$5
4
3
2
1
QD
10
20
35
55
80
$5
4
3
2
1
o
D
10 20 30 40 50 60 70 80
Quantity of Corn
Q
GRAPHING DEMAND
Price of Corn
Increase
in Quantity
Demanded
P
CORN
P
$5
4
3
2
1
QD
10 30
20 40
35 60
55 80
80 +
$5
4
3
2
1
o
Increase
in
Demand
10 20 30 40 50 60 70 80
Quantity of Corn
D’
D
Q
A change in Supply versus a change in
the Quantity Supplied
Change in Supply
Change in Quantity
Supplied
√ Moves the curve
•Costs of Production
•Future Expectations
•# of Sellers
√ Moves Along the SAME
curve
• Caused only by Price
change.
•Taxes and Subsidies
•Prices of goods using same resources
•Time period of production
Price Change
Price of Corn
P
CORN
P
$5
4
3
2
1
QD
10
20
35
55
80
S
$5
4
3
2
1
o
10 20 30 40 50 60 70 80
Quantity of Corn
Q
GRAPHING SUPPLY
Price of Corn
P
$5
4
3
2
1
Increase
in
Supply
S
S’
CORN
P QS
$5
4
3
Increase 2
in Quantity 1
Supplied
o
10 20 30 40 50 60 70 80
Quantity of Corn
Q
60 80
50 70
35 60
20 45
5 30
Verbal Clues
•
•
•
•
•
•
•
•
•
•
•
Use a correctly labeled graph and show…
Analyze the effect…
Explain the mechanism…
Identify the area of…
Show the impact…
Calculate (number and process)…
Show price and output…
Compare before and after…
Two separate graphs correctly labeled graph
Side-by-side
What is the relationship…
Distinguish between:
• Price and price level
• AD and D
ASlr
Price Level
• AS and S
ASsr
PL
1
AD1
o
Qf
Real domestic output
GROSS DOMESTIC PRODUCT
Defining…
Market Value of the total goods
and services produced within
the boundaries of the US
whether by Americans or
foreigners in one year.
GROSS DOMESTIC PRODUCT
Expenditures Approach
Consumption
by Households
Income Approach
Wages
+
Expenditures
+
Rents
+
Interest
+
Profits
+
Statistical
by Foreigners
Adjustments
+
Investment
G
by Businesses
=
=
D
+
Government
P
Purchases
NOMINAL GDP vs. REAL GDP
Nominal GDP
… reflects the current price level of goods and services and
ignores the effect of inflation on the growth of GDP.
… this measure is called Current Dollar GDP.
Real GDP
… measures the value of goods and services adjusted for
change in the price level. It will reflect the real change in
output.
… This measure is called the Constant Dollar GDP.
… indicates what the GDP would be if the purchasing power of
the dollar has not changed from what it was in a base year. The
government currently uses 2000 as its base year for Real GDP
measurement.
GDP Price Index
Price Index
in a given =
year
Real GDP =
Price of market basket
in specific year
Price of same market
basket in base year
Nominal GDP
Price Index
(in hundredths)
x 100
Disposable Income
By subtracting from Personal Income,
the dollars lost to taxes, we have the
Disposable Income. This is the “bottom”
line of national income accounting.
Disposable Income = C + S
Unemployment Rate =
Unemployed
Labor Force
Frictional – “temporary”, “transitional”,
“short-term” (“between jobs” or “search”
unemployment) (seasonal work)
Structural – “technological” or “long term”.
basic changes in the “structure” of the labor
force which make certain “skills obsolete”.
Cyclical – “economic downturns” in the
business cycle.
The Full employment rate of
unemployment or the Natural
Rate of Unemployment (NRU) is
present when the economy is
producing its potential output.
The Natural Rate of Unemployment
exists when the cyclical unemployment
is zero.
GDP Gap and Okun’s Law
√ The basic loss of unemployment is forgone
output.
√ Potential GDP is the capacity of the economy
assuming the Natural Rate of Unemployment.
The growth of the Potential GDP assumes the
normal growth rate of the real GDP.
√ GDP GAP is the amount by which actual GDP
falls short of potential GDP
For every 1% the unemployment rate exceeds
the natural rate…Approximately a 2% GDP Gap
occurs.
Inflation A rising of the general level of prices
Price of the market basket
CPI = in the particular year
x 100
Price of the same market
basket in 2000
Producer Price Index (PPI) Prices at the
wholesale or production level which are
early indicators of inflation.
Real and Nominal Income
Nominal income … is the number of dollars
earned as rent, wages, interest or profit
Real income… measures the amount of
goods and services nominal income can buy.
√ If nominal income rises faster than price
level, real income will rise.
√ If the price level increases faster than
nominal income, then real income will fall.
√ Your real income falls only when nominal
income fails to keep up with inflation.
Long Run Equilibrium
Price Level
ASlr
PL1
o
In the extended
ASsr AD-AS model,
equilibrium
occurs at the
intersection of
AD and the ASlr
and the ASsr.
Qf is the amount
of Real GDP at
full employment.
AD1
Qf
Real domestic output
Price Level
DEMAND-PULL INFLATION
and Self-Correction
PL3[7%]
ASlr AS2sr
ASsr
c
b
PL2[5%]
PL1[2%]
Short Run—
Increase in AD
shows point b
a
AD2
o
AD1
Qf
Long Run
Nominal Wages
rise and AS2sr
moves left.
RGDP returns
to previous
level on Aslr
But…PL rises
even more to
PL3!
Y2 Real domestic output
Price Level
COST-PUSH INFLATION
with government action
ASlr AS2sr
ASsr
c
PL3[5%]
b
PL2[3%]
a
PL1[2%]
o
Y
Q
2
f
AD1
If government
stimulates AD to
dotted line, an
inflationary spiral
will occur…PL3 at
Qf. We have Full
Employment but at
a higher price level.
AD2
Real domestic output
Price Level
COST-PUSH INFLATION
with NO government action
ASlr AS2sr
c
PL3[5%]
a
PL1[2%]
o
If government lets
ASsr
the recession take
its course, nominal
wages will fall in
the long run and
return to point
a…PL1 at Qf.
AD1
Qf
Real domestic output
Price Level
Recession
ASlr AS1sr
AS2sr
a
PL1[5%]
PL2[3%]
b
This decline in
the price level
will eventually
shift the AS1sr to
AS2sr. Price level
declines to PL3
at Qf . Shown at
point c.
c
PL3[2%]
AD1
o
AD2
Y2
Qf
Real domestic output
The Phillips Curve Concept
Annual rate of inflation
7
As inflation declines...
6
5
4
Unemployment
increases
3
2
1
0
PC
1
2
3
4
5
6
7
Unemployment rate (percent)
The Phillips Curve
Summary
The short run Phillips Curve is downward sloping.
Aggregate Demand changes move along the same
short run Phillips curve.
Aggregate Supply changes create new short run
Phillips curves.
√ In the long run, there is not a stable relationship
between unemployment and inflation.
√ The long-run Phillips curve is the vertical line at the
natural rate of unemployment.
Expansionary Fiscal Policy
Goal: To Reduce Unemployment and Effects
of Recession…
√ Increase Government Spending
√ Decrease Tax Rates
…Or Combination of the Two
Contractionary Fiscal Policy
Goal: To Reduce Demand—Pull Inflation…
√ Decrease Government Spending
√ Increase Tax Rates
…Or Combination of the Two
EXPANSIONARY FISCAL POLICY
the multiplier at work...
$20 billion decrease in tax rates; $15 billion in
new consumption spending
Price level
AS
MPS = .25
$60 billion
increase in
Aggregate
Demand
P2
P1
AD1
$490 $550
AD2
Real GDP (billions)
CONTRACTIONARY FISCAL POLICY
the multiplier at work...
$20 billion increase in tax rates; $15 billion lost
in consumption spending
Price level
AS
MPS = .25
$60 billion
decrease in
Aggregate
Demand
P2
P1
AD4
$490 $550
AD3
Real GDP (billions)
Built-in Stability
Some changes in relative levels of government
expenditures and taxes occur automatically.
This is not like discretionary changes in spending
and tax rates since these net tax revenues vary
directly with RGDP.
…tends to increase the government deficit (or
reduce the surplus) during recession or to increase
the surplus ( or reduce the deficit) during inflation
without requiring specific action by policy makers.
Real Interest Rate, (percent)
Crowding —Out Effect
Increased
demand for
loanable funds
by government
raises the
interest rate.
S
i%
i%
D2
D
LF0 LF1
Quantity of Loanable Funds
Fiscal policy weakened by NET EXPORT EFFECT
Expansionary fiscal policy
Problem: Recession
More government spending
and/or lower taxes
Contractionary fiscal policy
Problem: Inflation
Lower government spending and/or
higher taxes
Higher domestic interest rates
(crowding-out effect)
Lower domestic interest rates
(government role in loanable funds
market is less)
Increased foreign demand for
dollars (foreigners want to earn
higher interest)
Dollar appreciates
Net Exports decline
(AD decreases, partially
offsetting expansionary policy)
Decreased foreign demand for dollars
(foreigners find
higher rates elsewhere)
Dollar depreciates
Net Exports increase
(AD increases, partially offsetting
contractionary policy)
Supply-Side Economics
Supply-Side Economics aims to manipulate aggregate supply by
enacting policies designed to stimulate incentives to work, to
save and invest (including measures to encourage
entrepreneurship).
These policies may include tax cuts which will increase
disposable incomes, thus increasing household saving and
increase the profitability of investments by businesses.
•Tax cut stimulates more consumption, saving and investment to
increase AD.
•The new investment moves the AS curve to the right. Work
incentives push more workers into employment and they spend
and save increasing AD further.
•Low taxes act to push risk takers to move toward new
production methods and new products.
Laffer Curve
…shows the relationship between tax rates
and tax revenues
√ Up to a point, higher tax rates will result
in larger tax revenues.
√ But still higher tax rates will adversely
affect incentives to work and produce,
reducing the size of the tax base and
reducing tax revenues.
√ Lower tax rates will lessen tax evasion
and avoidance, and reduce government
transfer payments.
THE LAFFER CURVE
Tax rate (percent)
100
l
0
Tax revenue (dollars)
THE LAFFER CURVE
Tax rate (percent)
100
m
l
0
Tax revenue (dollars)
THE LAFFER CURVE
100
Tax rate (percent)
n
m
l
0
Tax revenue (dollars)
THE LAFFER CURVE
Tax rate (percent)
100
n
m
m
Maximum
Tax
Revenue
l
0
Tax revenue (dollars)
M
M
O
N
E
Y
E
A
S
U
R
E
S
• Large time deposits
+
• Money market accounts
• Savings deposits
• Small time deposits
M3
M2
+
• Checkable deposits
• Travelers checks
• Currency
MI
The Money Market
i%
i%1
Sm
Supply of
money is a
vertical line
since monetary
authorities
(FED) and
financial
institutions
have provided
Dm the economy
with a certain
stock of money.
$$ demanded
Creation of Money in the Banking System
Money supply can be increased when:
1. Banks issue loans to customers and receive a
demand deposit.
2. Banks buy securities from the public and credit a
demand deposit for the cost.
Money supply will be decreased when:
1. Customers repay loans and take money from
their demand deposit.
2. Banks sell securities to the public and a
demand deposit is reduced to pay for the bond.
√ One bank can loan only its excess reserves and is
limited by those reserves in creating money.
√ The banking system creates a “multiplied”
amount.
The Money Multiplier
1
=
Money
Multiplier
Required reserve ratio
Maximum
DemandDeposit
creation
=
Excess
reserves
x
Money
Multiplier
Currency drain and no creditable customers will
decrease the amount multiplied.
EASY MONEY Goal: Cheap, available credit;
increase the money supply
MS
i% In
C
AD
PL
RGDP
Actions
• FED will
buy
government
bonds from
banks and
the public
• FED will lower the
legal reserve ratio
• FED will lower
the discount rate
charged to member
banks
Results
¦ Increase
the bank
excess
reserves, and
banks can
make more
loans.
An increase in the
money supply will
lower the interest rate,
causing Investment to
increase and
equilibrium GDP to
rise.
The amount of the
change will be
dependent on the
size of the Income
Multiplier (1/MPS)
Easy money is reinforced by the Net Export Effect
Easy Monetary Policy And Equilibrium GDP
Real rate of interest, i
Sm1 Sm2 Sm3
10
10
8
8
6
6
Dm
0
Quantity of money demanded and supplied
PL3
PL2
PL1
0
Amount of investment, i
If the Money Supply
Increases to Stimulate
the Economy…
Interest Rate Decreases
Investment Increases
AD & GDP Increases
AD3(I=$25)
with slight inflation
AD2(I=$20)
Increasing money supply
AD1(I=$15)
continues the growth –
Real domestic output, GDP
but, watch Price Level.
AS
Price level
Investment
Demand
Tight Money Goal: Restrict credit; decrease the
money supply
MS
i%
Actions
Results
In
• FED will
sell
government
bonds to
banks and
the public
¦ Decrease
the bank
excess
reserves, and
banks will
issue fewer
loans
C
AD
PL
RGDP
• FED will raise the
legal reserve ratio
• FED will raise
the discount rate
charged to
member banks
An decrease in the
money supply will raise
the interest rate,
causing Investment to
increase and
equilibrium GDP to
fall.
The amount of the
change will be
dependent on the
size of the Income
Multiplier (1/MPS)
Tight money is reinforced by the Net Export Effect
Tight Monetary Policy And Equilibrium GDP
Real rate of interest, i
Sm3 Sm2 Sm1
10
10
8
8
6
6
Dm
0
Quantity of money demanded and supplied
PL1
PL2
PL3
0
Amount of investment, i
If the Money Supply
Decreases to “cool”
the Economy…
Interest Rate Increases
Investment Decreases
AD & GDP Decreases
with lower PL
AD1(I=$25)
AD2(I=$20)
Decreasing money supply
AD3(I=$15)
continues the “cooling” –
Real domestic output, GDP
as Price Level falls.
AS
Price level
Investment
Demand
Nominal Rate =
Real Interest rate + expected rate
of inflation
Real Interest Rate =
Nominal rate—expected rate of
inflation
ANTICIPATED INFLATION
11%
=
+
5%
Nominal
Interest
Rate
Real
Interest
Rate
6%
Inflation
Premium
Money Market
Graph—Nominal
Interest Rate
i
%
Sm
The supply of money is
vertical no matter what
the interest rate is on
the vertical axis. The
FED controls the
supply of money.
i%e
Qe
Q of $$
demanded
The demand for
money is
composed of the
Dmtransaction
demand and
asset demand.
Loanable Funds Market—Real
Demand is:
Interest Rate
r
SLF
• Business for investment
• Consumer for spending
re
• Government for Deficit
spending
DLF
Qe
Q of LF
Supply is mostly from
private savings
Changes in the real interest rate caused by
movements of demand (from borrowers) and supply
(from savers).
Classical View:
determines the output at
Qf
√ AD is stable and
determines the price
level as long as money
supply is stable.
√ If AD is unstable,
prices and wages adjust.
Price Level
√ AS is vertical and
AS
P1
P2
AD1
AD2
Qf
Real Domestic Output
A shift to AD2 shows
that the price level
declines.
Keynesian View:
AS
Price Level
√ Product prices and
wages are downward
inflexible
√ AS is horizontal up to
P1
Qf then becomes
AD1
vertical
AD2
√ If AD is unstable,
Q2
Qf
changes in AD have no
Real Domestic Output
effect on PL but affect
Movement from AD1 to AD2
RGDP.
reduces the Real GDP but
the PL remains constant.
NEW CLASSICAL VIEW OF SELF-CORRECTION
Price Level
Self-Correction
P3
P2
P1
AD increases
ASLR
AS1 moves economy
from a to b.
Price level rises
(P2) and then
c
self-correction
b
to c by shifting
a
AD2 left to AS2 as
Nominal Wages
AD1
rise.
AS2
Q1
Real Domestic Output
Monetary rule : supported by Monetarists
and other Neo-Classical Economists like
Rational Expectationists. …directs the
Fed to expand the money supply each
year at the same annual rate as the
typical growth of the economy’s
productive capacity.
Discretionary Fiscal and Monetary
Policy (especially monetary): supported
by Mainstream Economists.
Summary of Alternative Views
New Classical Economics
Issue
Monetarism
Rationa l
expectations
Stable in long run
at natural ra te of
unemployment
Inappropriate
monetary policy
Stable in long run
at natural ra te of
unemployment
Unanticipated AD
and AS shocks in
the short r un
Monetary rule
Monetary rule
By directly
changing AD
which changes
GDP
No effect on o utput
because price-level
changes are
anticipated
View of
velocity of
money
How fiscal
policy affects
the econo my
Active fiscal and
monetary
By changing
interest rat es,
changing
investment and
real GDP
Unstable
Stable
No consensus
Changes AD and
GDP via the
multipl ier
No effect unless
money suppl y
changes
View of Cost
push infl ation
Possibl e (wagepush, AS shock)
Imp ossible in long
run in absence of
excessive money
suppl y gro wth
No effect on o utput
because price-level
changes are
anticipated
Imp ossible in long
run in absence of
excessive money
suppl y gro wth
View of the
private
economy
Cause of
observed
stabili ty of
private
economy
Appropriate
macro policy
How chang es
in money
suppl y affect
the econo my
Mainstream
Macroeconomics
Keynesian Based
Potenti ally
unstable
Investment does
not equal saving
causing chang es in
AD; AS shocks
Deficits, Surpluses and Debt
A budget deficit is the amount by which the
government expenditure exceeds the
government revenue in a particular year.
A budget surplus is the amount by which
the government revenue exceeds the
government expenditure in a particular
year.
The National or Public Debt is the
accumulated deficits and surpluses of the
government over time.
Types of Budgets
Annually Balanced—procyclical
Cyclically Balanced—to hard to
predict cycles
Functional Finance-work for goals
√ Comparative Advantage …is the ability to
produce an item at a lower opportunity cost. Resources are
scarce, so that one can only produce more of one product
by taking the resources away from another. It means that
total world output will be greatest when each good is
produced by the nation which has the lowest domestic
opportunity cost.
√ As a result of trade, countries that trade products based
on their own specialization will have more of BOTH
products (produced and traded for).
√ Terms of Trade…the exchange ratio between goods
traded. This ratio explains how the gains from
international specialization and trade are divided
among the trading nations; it depends on the world
supply and demand for the two products.
Flexible exchange rates
S
$ Price of
Foreign
Currency
The intersection
will be the
exchange rate.
$fc
D
Qfc
Quantity of Foreign Currency
A nation’s Balance of Payments
records all the transactions that take
place between its residents and the
residents of a foreign nation.
Current Account
Capital Account
Mdse. Trade
Real Investment
Services Trade
Financial Investments
Net Investment
Income
Net Transfers
=
Official Reserves Account
+ to balance a deficit
—to balance a surplus
The Market For Currency
S
FC
Depreciates;
$ Appreciates
FC price of dollars
Dollar price of foreign currency
S
Dollar
Depreciates;
FC Appreciates
FCP/$
Dollar
Appreciates;
FC Depreciates
$P/fc
D
FC
Appreciates;
$ Depreciates
Q
D
Q Quantity of foreign currency
Quantity of $
Determinants of exchange rates:
 Changes in tastes
 Changes in relative incomes
 Changes in relative prices
 Changes in relative interest rates
 Speculation in currencies